Cameron School of Business

UNIVERSITY OF NORTH CAROLINA WILMINGTON

An Introduction to Finance

Edward Graham
Professor of Finance
Department of Economics and
Finance

Copyright© 2007
 Continuing your Introduction to Finance

Recalling the Broad Introduction to Finance

I. The Three Primary Duties of the Financial Manager

II. The Concept of Risk and Return

III. Capital Structure Choice

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 An Introduction to Finance

What is finance?

• Finance is the study of the art and the science of money

management; it is based on the Latin root finis,
meaning the end. In managing ours or our firm’s money,
we consider historical outcomes or “endings,”
and we propose future results as a function of decisions
made today. Those outcomes or results are
typically portrayed using financial statements.

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 I. The Three Primary Duties of the
Financial Manager

Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:

•The capital budgeting decision

•The capital structure decision

•The working capital decision

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 The Concept of Risk and Return
• We are past the half-way point. Celebrate.

• Now, back to work!

• In Chapter 10, we examine the stock market, not towards learning how to
beat it, as that is highly unlikely, but in merely seeking to better
understand it.

• So, what about the stock market and stock returns? What is a stock
return?

Recalling the Dividend Growth Model or DGM, we remember that:

R = D1/Po + g, or our return is comprised of a dividend

yield and a capital gains yield. (p. 292-294)

Or, for a $20 share of Duke Energy expected to pay an

$.80 dividend and sell for $22 in a year, our expected
return becomes:
R = .8/20 + .10 = .14

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 The Concept of Risk and Return

• A fourteen percent return does not sound thundering, but

recalling the rule of 72, that is a return that doubles our money
every 5.2 years or so, that beats the stock market averages over
the past 50 or so years, and that turns our $20,000 investment
today into over $1,000,000 in less than 30 years. (Check it our with
your BA II Plus buddies)

• Historically, as with your text on page 295, and the table on page
296 (Table 10.4), we see typical stock and bond performances.

• The first lesson on those pages is that with higher returns comes
higher risk.

• A game-playing example in the next slide illustrates.

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 The Concept of Risk and Return
• The Risk Return Relationship

Imagine a game, or choice of games:

• Game A, you win $100,000

• Game B, you win $10,000,000 two percent of the time, the rest
of the time, you win nothing.

• Which game do you play?

• Expected value of Game A is $100,000
• Expected value of Game B = P(winnning) Winnings + P(losing)
Zero
Or .02(10 million) + .98 (0) or $200,000

And, 200,000 > 100,000

But, really, do you play Game B?

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 The Concept of Risk and Return
• Game B is far riskier, and that introduces our second lesson:

• The variability of returns. From chapter 10, we can appreciate the

importance of this topic as illustrated on pages 303-308 of your text.

• To go for the higher return of Game B, as with a risky stock, we must

accept far more risk as illustrated by the variability of Game B’s returns,
versus the risk-free guarantee of Game A.

• But, in life, there are few guarantees, so if you wish to “take a risk,”
recall that the stock market is widely considered to be “efficient.”

– There are three versions of an Efficient Market Hypothesis to

describe this efficiency: the weak form, the semi-strong form, and
the strong form. Each is illustrated by example. (pages 313-315)

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 The Concept of Risk and Return
• In Chapter 11, as introduced on pages 323-327, we underscore the
ideas of risk and return.

• For example, in our game-playing example, we could describe our

games’ returns thusly:

• Expected Return of Game A = Risk Free (Rf) portion + Risk

Premium (RP)
• Expected Return of Game B = Rf + Risk Premium, or

• E(A) = Rf + RP = 100,000 + 0
• E(B) = Rf + RP = 100,000 + 100,000

• In effect, you are not compensated for risk with Game A, and
you get a 100,000 bump in Game B for taking the risk. Further,
to not play Game B, in exchange for the guarantee of Game A,
you PAY $100,000 in insurance to assure a positive outcome,
forgoing the “expectation” of $200,000 with Game B.

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 The Concept of Risk and Return
• We extend the tradeoff of being compensated for risk with an investment
example:

• Suppose we have a risky asset “A,” with expected returns of 100% one-
half the time, and a loss of 50% half the time. This is contrasted with an
available risk-less or risk-free asset yielding 5%.

• E(A) = Rf + RP = .5(100%) + .5(-50%) = 25%.

– As we “know” there is a risk-free asset available yielding 5%, our

function is:

• E(A) = Rf + RP = .05 + .20. We are compensated, or we

demand, an additional return of 20% for taking the risk of asset
A, for risking that half the time we will lose half our money!

• And, to avoid this risk of a single asset, like asset A, we form

portfolios.

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 The Concept of Risk and Return
• Suppose we have 1 million dollars to invest, in bonds, real estate and
stocks. (This is covered in Section 11.2 on page 327 of your text)

• We decide to invest $250,000 in bonds yielding 8%, $300,000 in real

estate yielding 10%, and $450,000 in stock yielding 12%. These are
expected yields, by the way, and not guarantees! We are just hedging
our bets by not placing all our money in a single stock or even in a
single economic sector!

• Our Portfolio’s Expected Return is a weighted average:

• E(Rp) = W(b)R(b) + W(re)R(re) + W(s)R(s)

= (250,000/1m)(.08) + (300,000/1m)(.10) + (.45)(.12) = .104

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 The Concept of Risk and Return

We achieve a reduction in our portfolio’s variance as in Table 11.7

on page 335 and Figure 11.1 on page 336 with this portfolio.

In an environment with a t-bill or other risk-free asset yielding 3%,

our risk premium with this portfolio would be 7.4%.

We avoid, with this portfolio, most of the shock to any one sector
or industry (called non-systematic or non-economy-wide risk),
but with any risky investment or risky portfolio we still have
systematic or economic risk. (As on page 333 of your text in
Section 11.3).

With diversification, we get rid of most of the unsystematic or

diversifiable risk, but we can only get rid of the economy-wide
or non-diversifiable risk with t-bills or certificates of deposit.

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 The Concept of Risk and Return

• A model exists, Section 11.7 on pages 341-348 of your text, called the Capital
Asset Pricing Model or CAPM that describes the nature of risky asset returns as
a function of a risk-free guarantee, a risk-premium and the systematic risk of the
asset in question.

• We describe security expected returns or E(R)’s as the sum of a Risk-free return

and a Risk Premium.

– E(R) = Rf + Bi [ E(Rm) – Rf ], defining each term as in Table 11.9 on page

348. Bi is a measure of systematic or economy-wide risk – it is the measure
of the exposure of McDonald’s stock to the whole economy, for example,
and not just beef prices (that is an example of non-systematic risk). The
portion “Bi[E(Rm) – Rf]” is the Risk Premium. Rm is the expected return on
the market, like the S and P 500 stock index, for example.

– The CAPM “story” is told with the Security Market Line or SML, as in your
text on page 347. The SML is the central prediction of the CAPM.

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 The Capital Structure Decision
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.

Perhaps most importantly, the decision to fund a firm’s growth with

equity - such as with funds invested by the firm’s founders, angel
investors, venture capitalists or public stock offerings – or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:

• The risk of the debt

• The loss of control and reduced potential cash flows to the
founders with an equity or stock sale

We expand our review with a few capital structure decisions.

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 The Capital Structure Decision
• Recall that our overall objective as financial managers is to “borrow”
money at one rate of interest (letting that borrowing cost be an
assembly of our debt costs and our stockholders’ expected returns),
invest that money at a higher rate of return, and “keep the difference. In
this case, we keep the difference on behalf of our shareholders and
towards elevating our stock price.

• Table 12.1 on page 373 captures the spirit of the costs of capital
material in Chapter 12. There, we see that our “borrowing cost” above
becomes this curious weighted average cost of capital or:

• WACC = (E/V)Re + (D/V)Rd(1-Tc) or our WACC is simply the market-

valued weighted average of each of our debt and equity funding levels
times the respective costs of each of those funding sources. The debt
costs are reduced to the after-tax level of expense as interest is tax
deductible, but dividends and capital gains earned by shareholders are
not.

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 The Capital Structure Decision:
An Example

WACC = (E/V)Re + (D/V)Rd(1-Tc), with the factors defined.

E is the market value of outstanding equity
V is the market value of the firm, E + D
Re is the required return on equity using the DGM
or CAPM
D is the market value of outstanding debt
Rd is the pre-tax cost of borrowing, typically the
YTM on the firm’s bonds, or other published borrowing
costs
Tc is the marginal tax rate of the firm

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 The Capital Structure Decision:
An Example (continued)

WACC = (E/V)Re + (D/V)Rd(1-Tc), Tc, the tax rate, is 40%

Suppose a firm has 100 million shares of stock outstanding

trading at $50, E is just 50 x 100m or $5 billion.
Assume also the firm has 3 million 8% bonds outstanding
trading at $950. They have ten years to maturity, and pay an
annual coupon. D is $950 x 3m or $2.85 billion.
V = D + E = $5 billion + $2.85 billion = $7.85 billion

YTM? 1,000 FV, 80 PMT, 10 N, -950 PV, CPT I/Y = 8.77%

Re? Suppose the firm uses the CAPM (the firm could just as
easily use the DGM or some other method to estimate its costs
of equity), its beta is 1.2, treasury bills are yielding 1%, and the
expected market return is 8%.
Re = Rf + Bi(Rm–Rf) = .01 + 1.2(.08 - .01) = .01 + .084 = 9.4%

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 The Capital Structure Decision:
An Example (continued) WACC = (E/V)Re + (D/V)Rd(1-Tc)

E = $5b, D = $2.85b, V = $7.85b

E/V = the equity weight = (5/7.85) = .637,
D/V = the debt weight = (2.85/7.85) = 1 - .637 = .363
Rd = YTM = I/Y = 8.77% = .0877
Re = 9.4% (from the CAPM) = .094
Tc is still 40% or .4

WACC = (.637).094 + (.363).0877(.6) = .06 + .019 = 7.9%

What does this 7.9% WACC actually mean? It is the suggested

discount rate (NPV) or hurdle rate (IRR) that the firm should
use with “typical” projects of average risk for the firm. The
WACC has clear theoretical extensions to such theories as the
static tradeoff theory or the pecking order theory of capital
structure.

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